An extremist, not a fanatic

October 31, 2011

Politics & the crisis: two narratives

Paul raises a significant and surprisingly under-appreciated point - that there’s a worryingly wide gap between economic explanations of the crisis and political responses.

My preferred explanation for the crisis draws heavily upon Ravi Jagannathan’s (pdf). Put simply, the combination of China’s export-driven growth and the desire to build up FX reserves to prevent a repeat of the 1998 currency crises generated a glut of savings which was invested in western bonds, causing a fall in their yields.

In principle, this drop in interest rates might have triggered a boom in real capital spending. But it didn’t, perhaps because the “great stagnation” meant there was a dearth of investment opportunities. Instead, lower rates unleashed a bubble in house prices, the bursting of which brought down banks.

There are five features of this account which politicians ignore:

1. This is a global story, not a parochial one.

2. The squeeze on workers’ living standards is not merely due to high inflation (which is temporary) or to the legacy of the crash. It is also the result of the increased supply of labour created by China’s entry into the world economy.

3. Banks are not the prime mover here, but rather a conduit for these global forces. I mean this is in two senses. First, their creation of mortgage-backed securities was a response to demand; falling yields on proper AAA securities led to a “hunt for yield” which bankers thought they could satisfy by bundling up mortgages. Secondly, the counterpart of current account surpluses in Asia is current account deficits in the west. And a current account deficit, by definition, is an excess of investment over savings; investment here means house purchase, not just capital spending. But if a nation has an excess of investment over saving then it is likely that its banks will have to rely upon wholesale funding, because deposits (savings) will fall short of loans (investment). It is no accident that the “UK” domiciled banks that weathered the crisis were those that were properly globalized such as HSBC and Standard Chartered, and so able to call upon a large Asian deposit base. And it’s no accident that the banks that failed - Northern Rock, Bradford and Bingley - were dependent upon retail deposits, which were lacking.

4. The fact that the government was running a fiscal deficit before the crisis was not its fault. It was instead a simple accounting identity. If foreigners and companies are net savers, then other sectors must be net borrowers. This was partly the household sector, but also the government.

5. Policy can do little to raise growth. This is not merely because the effect of financial crises is to depress growth rates. It is because the crisis has its origin in large part in a decline in potential growth, which is what the dearth of investment opportunities represents. Deregulation or a “plan B” might ameliorate this problem, but they are unlikely to solve it.

What we have here, then, are two narratives between which there is an almighty gulf. There’s the economic narrative of the crisis. And there’s the party political narrative, which blames bankers’ greed, neoliberal economics, regulatory failure or Labour’s profligacy - all of which are only incidental features.

This, I suspect, helps explain or justify why there is so much apathy towards party politics, even amongst the most intelligent.

As for what could be done to change this, I would recommend that politicians stop pretending to have ways of getting us out of the mess, and focus instead upon how to more equitably distribute the hardship. A first step here would be to stop stigmatizing the unemployed.

Comments

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"And there’s the party political narrative, which blames bankers’ greed, neoliberal economics, regulatory failure or Labour’s profligacy - all of which are only incidental features."

This isn't really surprising. Each of these 'explanations' were ideological hobbyhorses of both the left and right before the financial crisis. The wonderful thing about having an ideology is that it provides you with instant answers to any particular political problem you may encounter.

I've seen this argument quite a bit and it makes a lot of sense. I don't follow this bit clearly though:

And a current account deficit, by definition, is an excess of investment over savings; investment here means house purchase, not just capital spending.

I understand the accounting identities etc and why new housebuilding is investment. But why should a secondary market house purchase be counted as investment - the money is just changing hands with the country, isn't it?

I agree with a lot of your narrative, but I think you're leaving out quite a large macro economic screw up, for example the declines in nominal spending seen in Eurozone, the US and the UK.

Poland and Sweden acted agressively to reflate their economies and are doing much better. The ECB raised rates just as we started slipping into the little depression (and have raised rates again recently) and the Fed have let everyone know they are allergic to inflation but like 9% unemployment just fine.

More aggressive action could have lessened the banking crisis for instance.

I think your story is very real (in the not nominal sense) in a useful way that doesn't suggest workers are unemployed because they suddenly value leisure very highly, but I think you're ignoring the nominal shock story which the little depression is about.

I wonder, is this something that's only true now? Or has it always been true that politicians have a massively inflated idea of how much actual change they are capable of effecting?

I'd be amenable to an argument that political leaders have been stronger in the past only in the sense of their ability to do disastrous things (think of the poor decisions of absolute monarchs), but that in terms of creating positive change, everyone's blowing in the four winds. So, in that, we've advanced, politically...

On point 2, it is rich to say that salaries stagnation and the ensuing income inequality only boils donw to cheap labour from China. You have written a lot about this, but things like the demise of unions and other institutional changes are equally powerful explanations. By the same token, it is the persisting neoliberal ideology that keep us from looking for practical solutions which ought to focussed primarily on the way labour markets function, and on how consumer sovereignity could be harnessed to bring about these changes.
These are political issues that require coordinated action at least at the EU level, using EU as a cartel-like instrument to raise social/welfare standards thus preventing a disastrous race to the bottom to appease large corporations.
The refusal to do so has all to do with political ideology and it would be squarely a political failure.

@ Jimmy, LO, Paolo - Yes, I'm leaving a lot out - it's a post, not a book. You're right to say there's other things going on - especially, Paolo, the many other reasons for rising inequality.
@ Matthew - If you buy a £200,000 house from me, your investment and my saving will indeed net out, as long as I save all the proceeds (say by paying down debt). However, if I use some of the proceeds for consumption, then I - S is positive, and cet. par. there will be a current account deficit.

There creation of Mortgage backed securities was Financial Engineering also known as Fraud. People in finance knew the consequences of their actions but did not care as they were extracting bonuses.

The banks/building societies that failed expanded using the short term wholesale money markets (not deposits).

House purchases are not investment but asset inflation.

Presence of a surplus in Asia does not imply the need to consume the surplus in the West.

Economics reputation as an excuse for the rich is again reenforced. After all who since the seventies have the Rich experienced substantial increases in wealth, while the rest especially the poor have not.

Having quickly scanned Jagannathan’s argument, (between my last post and now) I am much nearer Obsfeld and Rogoff, which leaves plenty of scope for failure by the West's political elite and the bankers (fraud).

Jagannathan’s argument does not justify your analysis. The economic system is not a mechanical device subject to the laws of physics.

Obviously outsourcing and globalisation are factors. But we were not helpless in the face of free markets and Chinese
policies.

This crisis was a massive failure of Western policy, Finance and the neoliberal ideology.

How come it is not the Chinese or the banks experiencing the losses (transferred to the Western Sovereigns) from the collapse of housing bubble ?

If the banks weren't the prime movers, but just a conduit of the knock on effects of vaster, epochal forces stirring in Asia, then surely the vast expansion of financial services in the West should have post dated, or at least merely kept step with,the development of India and China?

But my understanding is that the shift to financialisation and debt based Western economies can be empirically demonstrated to have occurred first, as a response to the lack of investment opportunities presenting themselves in the 'real economies' of the Western Powers, perhaps from the mid sixties onwards.

Your outline account is attractive, but for this point- because the implication is that the banks (by which I mean the financial sector as a whole) are basically blameless. Whereas I feel they have been systematically misdirecting surpluses and wildly creating 'fictitious capital'

I look forward to using the logic of point 4 on my wife when I come home from the pub on Friday night: "No dear, you see it's not my fault that I'm drunk. Others were net producers of alcohol, so I had to be a net consumer. It's a simple accounting identity."

HSBC et al weren't the only banks to weather the crisis in good order - Lloyds TSB did OK (up until the Merger From Hell), largely due to a history of being "steady", "cautious", "not reckless" and other boring things. Your argument is a bit like saying that Northern Rock and RBS switched to roulette when the cards started going against them - it has the explanatory value of being true, but doesn't mean that what they did was the only choice available.

This sort of explanation is open to criticism as it does require that institutions on the receiving side of Global imbalances in the UK, USA and Euroland choose to both absorb excess savings and direct them badly to housing finance. It is not ideological to point out that this was a collective choice and not the fault of Chinese or Indian workers. It is also not clear to me why it is impossible to boost demand by expanding base money and NGDP level targeting in western economies? Foreign capital imbalances do not prevent monetary policy choices from having effect. The excess savings in China and Asia generally are not an excuse for Central banks and Governments sitting around doing nothing. Or actually making things worse by spending cuts. If the private sector does not want to invest as it lacks confidence in private returns the state can still invest in social capital that generates a return to society overall. It is "ideological" I suppose to point out it is not necessary for all Investments to make a private return. But until recently any one educated in economics would not have just ignored the obvious implications of this conclusion. Are not our problems a direct result of the very ideological policy choice of tying all policy debate to the need to create a private gain for Banks and investors? rather than sorting out the mess in a way that is good for society and its members?

The housing bubble was also driven by leveraged speculation - just like all other bubbles in history. Household debt:income ratios just got unsustainably high.

Low interest rates are not a sufficient condition for a housing bubble. Having irresponsible mortage lenders who believe prices will always rise is also important. Lenders could have stopped the housing bubble if they saw it for what it was - and neoclassical economics did not make this possible.

Also, policy can do *a lot* to improve growth. How can you look at Chinese growth, mainly driven by government-sponsored investment and conclude that government is powerless to drive the economy? Private sector deleveraging is easy if the economy is booming due to government investment.

"Also, policy can do *a lot* to improve growth. How can you look at Chinese growth, mainly driven by government-sponsored investment and conclude that government is powerless to drive the economy?"

So ..... if we assume that Chinese growth is mainly driven by government-sponsored investment, we're able to arrive at a conclusion that government-sponsored investment can be the driving force of overall economic growth. Great! But this doesn't tell us much really, does it? Not until we can actually establish, rather than just assume, a direct causational link between Chinese government investment and general Chinese economic growth.

I accept that State investment will create economic activity where otherwise there may have been none - just as you can create a fire with lighted paper at the bottom of a pile of leaves. But the purpose of the latter is to create the circumstance in which the leaves will ignite, and the burning of leaves will cause yet more leaves to ignite - and without causing this "chain reaction" the whole process is worthless. Exactly the same principle applies to stimulatory spending - unless the general economy is in a dry enough state to combust when exposed to an exogenous fire, there's no point in wasting paper trying to start this process.

Your theory assumes that State borrowing to finance stimulus is neutral to the propensity to save. I'd argue against this. It seems to me to be more likely that the more the general population expects future tax increases, the more they will defer consumption in the present; that fiscal expansion financed by borrowing will therefore be blunted in its impact; and that perhaps the increased propensity to save of companies and well-off individuals is partly related to an observation that Western governments are becoming more Statist in nature, and will therefore be likely to raise future taxation levels.

Could it be that central to the general reluctance to spend and invest is the feeling that the political direction is towards a reduction of freedom of manoeuvre, and that the more reserves one holds, the more possible it is that this reduction of freedom can be mitigated?

Yes, state borrowing to finance stimulus in a recession boosts private sector jobs and incomes and borrowing. Why? Because government is filling in the output gap caused by insufficient demand.

Remember that government borrowing creates credit just like private sector borrowing. If everyone, in aggregate, pays down debt at the same time, bank balance sheets (and hence the stock of money) will shrink. That's why government needs to borrow to offset private sector deleveraging.

The Ricardian equivalence / crowding out story you seem to tell is only plausible when the private sector is growing healthily and excessive government borrowing on top of this then boosts inflation and leads to interest rates and tax increases.